Bitcoin and Cryptocurrency Speculation

In recent news, there has been considerable focus on bitcoin and its dramatic price swings. In March of 2014, I attended 500 Startups Bitcoinference. At the conference, the price of one bitcoin was approximately $580 and, soon after the conference, the IRS declared that bitcoin would be taxed as a property. In 2017, the price of bitcoin increased from $900 to over $20,000, thereby creating a number of crypto millionaires with one buying a Lamborghini based on $115 of purchased bitcoin. As of early 2018 the price of bitcoin was around $10,000 with news that the European Central Bank (ECB) will not ban or regulate cryptocurrencies. However, many traders are closely watching the regulatory developments in South Korea, Japan and China which could cause significant price swings. One of the founders of a cryptocurrency was asked his forecast for the prices of cryptocurrencies and he gave the only reasonable and honest answer: “I have no idea.”

Along with price fluctuations, bitcoin has been in the news due to fraud and theft. In December 2017, a Slovenian website NiceHash, was hacked and lost about $77 million in cryptocurrency. Reuters, the global wire service, estimates that $15 billion of bitcoin have been stolen. Along with theft, there is the risk of fraud and the SEC has recently launched a Cyber Unit. In December 2017, the SEC froze the assets of PlexCorps and halted the sale of their Initial Coin Offering or ICO. (ICOs are ways that companies use cryptocurrency or tokens to raise money and we will review these later.)

What is a Bitcoin?

First, what is a bitcoin and why does it matter? Bitcoin is the first decentralized digital currency that enables the transfer of value from one person to another person without going through an institutional intermediary such as a bank or clearing house. In other words, I can send you money in the form of bitcoin without using Visa, PayPal, Western Union, Square, etc. You can then keep the bitcoin or exchange it for dollars, euros or another type of cryptocurrency such as Litecoin.

Why should we avoid Visa and PayPal? By removing the institutional intermediaries, there are obvious advantages. First, we can dramatically reduce transaction fees. For example, to send $50 by West Union, you should plan for about $5 in fees. To send money internationally, you will spend more, because along with fees, they will charge you to convert the currency. The fees for sending $50 worth of bitcoins is currently between five and fifty cents, which is much better. (Note: If you use a wallet such as Coinbase, then they will charge a fee but it will be significantly less.) Also, institutional intermediaries insist on minimal transaction amounts similar to how many shop owners insist on a minimal amount for credit card purchases. For vendors, fees and chargebacks make very small or micropayments unprofitable and, for some consumers, there are psychological hurdles as mobile and digital buying is already challenging and making frequent purchases could exacerbate these frictions.

What is a Blockchain?

For bitcoin to work, the inventors had to solve a few problems. First, there is a need to keep track of the transfer of value without agreeing on someone to keep a ledger of all activity. Second, there is the problem of double-spending–someone using a bitcoin to buy from you one day and, a few days later, using the same bitcoins to buy from another person.

To solve these problems, a person or persons by the name of Satoshi Nakamoto designed and created the blockchain. The blockchain provides bitcoin with a public ledger with ordered and timestamped transactions and is based on the cryptography rather than trust.

A blockchain is a distributed ledger with each block containing a) transaction data, b) a unique identifier for the block or hash of the block, and c) a unique identifier for the previous block or hash of the previous block. The transaction data depends on the type of blockchain but a bitcoin blockchain will store the bitcoin’s sender, receiver, and amount. The hash of the blockchain can be compared to a fingerprint that identifies a block and all of its contents. Once a block is created, its hash is calculated. If you change anything in the block, then you cause the hash to change. Finally, the blockchain contains the hash of the previous block and this creates a chain of blocks, hence, the name, blockchain.

The blockchain has a few interesting and creative security features. Today’s computers can very quickly create a hash. Therefore, someone could change the data of a block and then very rapidly recalculate all the hashes of the other blocks to make the new data appear as original and valid. To slow down the creation of blocks, blockchains require a proof-of-work or the computation of a meaningless but extremely difficult math problem before creating a new block. Now, creating a block requires the dedication of computer power, and when a bitcoin block is created, the creator or miner is rewarded with bitcoin. Also, there isn’t just one blockchain or ledger. Instead, anyone can get access to the blockchain and everyone is allowed to join. When someone joins the blockchain network, they get a full copy of the blockchain. When a new block is created, each member of the blockchain, or node, gets the new blockchain and they must all agree that it is valid and agrees with the current blockchain. All of the nodes create a consensus that the new block is valid.

These three requirements–creative use of hashing by linking, proof-of-work mechanism, and the distributed network–make it almost impossible and highly impractical to tamper with the blockchain. These simple cryptography tricks make the blockchain and bitcoin possible and create other commercial advantages. First, the lower transaction costs enable low/no-cost global payments and lower minimal practical transaction costs or micropayments. Second, the non-reversible transactions reduce the amount of information required by the payee. For example, unlike writing a check, there is no need to provide a signature and show a proof of identification such as a driver’s license or identification card. Finally, and to me, most importantly, the blockchain may support the transfer of other non-currency things of value such as deeds, digital rights, or voting decisions, and these transfers can all be made with an open-source, P2P distributed network that costs sender and receiver no money.

Smart Contracts

Blockchains are constantly evolving and a recent development is the creation of smart contracts, simple programs stored on a blockchain which can be used to automatically exchange coins based on certain conditions.

In 1987, smart contracts were invented by Nick Szabo, who is a computer scientist, law scholar and cryptographer as a distributed ledger for stored contracts. Smart contracts act exactly like real contracts but are completely digital and based on small computer programs that are stored inside the blockchain.

An Example (Kickstarter)

Kickstarter offers an example of how smart contracts work. Using Kickstarter, a small team of inventors or creators can ask supporters to send them money. The creative team agrees that they will only collect money from supporters if they achieve their funding goal by a certain time. Kickstarter will collect money from the supporters and hold the money until either the funding goal is achieved or the time has expired. If the goal is achieved, then Kickstarter sends the money to the creative team. If time expires before reaching the goal, then Kickstarter returns the money to the supporters.

A smart contract can provide the same functionality, however, without Kickstarter and their associated fees. The supporters can send their funds to the blockchain, the stored program will determine if the goal is achieved or time has expired without success, and, based on the results of the stored program, funds are either sent to the creative team or returned to the supporters. And this can occur all without an institutional intermediary.

Crowdfunding is a great use case for smart contracts. Others include: in banking, loan issuance and automated payments; in insurance, claims processing; and, in postal services, payment on delivery. There are many more.

Because the smart contract relies on blockchain, the smart contract inherits the associated security features. First, the smart contracts are immutable. After a smart contract is created, it can never be changed. Second, smart contracts are managed by a distributed network and the output of the contract must be validated by everyone on the network. A single person or node cannot force the actions of a contract.

In 2013, Vitalik Buterin proposed a new blockchain, Ethereum, and currency, Ether, which were specifically designed and created for smart contracts. Ethereum smart contracts are programmed using a programming language called Solidity which is very similar to Javascript. Interestingly, bitcoin also has support for smart contracts but the original designers limited the functionality for security reasons.

Initial Coin Offering (ICO)

An initial coin offering (ICO) typically involves selling a new digital currency or “token” as a way to raise money for a company or project. Unlike equity or debt, the token does not confer ownership rights or payment obligations. Buyers of ICOs range from venture capitalists and family offices to high net worth individuals to individual investors.

An ICO is a type of smart contract for crowdfunding by issuing a token. The token can be used to access or purchase the resources of the project.

Here is the best example of an ICO that, to date, I’ve heard. Pretend that you are planning to build a video arcade (if you can remember going to the video arcade, then please stand up and give yourself an OG pat on the back). To fund the arcade construction and purchase or lease of video games, you need to raise money from family, friends, and investors. Instead of offering debt or equity, you decide to offer your financial supporters tokens that they can use to play the games. For example, a $500 investment could warrant 5,000 tokens. Since the supporters know that most video games will cost $0.25 and they love playing arcade games, they may be willing to buy the tokens. However, please be aware, there may be some investors who have no interest in arcade games and are only waiting for the price of the tokens to increase.

Through ICOs, companies are now offering tokens to potential investors. Like the fluctuating price and theft of cryptocurrencies such as bitcoin, ICOs have attracted attention due to regulatory concerns and fraud. However, in 2017, companies raised over $4.8 billion using ICOs.

Most of the funding for ICOs has gone to companies that are building the cryptocurrency and blockchain infrastructure for future businesses and opportunities. This build-out is very similar to the build-out of the telecom industry that was led by people such as Ted Turner of the Turner Broadcasting Systems (now CNN and Time Warner through acquisition) and John Malone of TCI (now AT&T through acquisition). Telecommunications build-out was too capital intensive to be funded by the traditional financial instruments of Wall Street. Instead, Michael Milken perfected the design and issuance of high-yield corporate bond or junk bonds to fund telecommunications. I believe that ICOs will provide a similar funding mechanism for the build-out of the future of online technology.

By providing $4.8 billion of fresh capital to technology startups (2018 appears on track for a significant increase), the technologies of bitcoin, blockchain, smart contracts, and ICOs have had a major impact on Silicon Valley startups. As this infrastructure spawns newer technologies and business models, you will see dramatic innovation and transformation and the transition to Internet 3.0.

SAT Questions

Let’s finish our discussion of bitcoin and blockchain with a few Scholastic Assessment Test (SAT) questions.

NAPSTER : TOWER RECORDS

A. bitcoin : Visa’s payment gateway

B. bitcoin : Chicago Title Company

C. bitcoin : NYSE, Nasdaq, CME

D. bitcoin : any value transfer system with high complexity and high costs (too many to list)

F. all of the above and more

TCP/IP : INFORMATION REVOLUTION

A. blockchain : value revolution

B. blockchain : trust revolution

C. all of the above

Blockchains can used for…

A. storing medical records

B. creating digital notary for documents

C. collecting taxes without an Internal Revenue Service

D. all of the above

Which inventions lead to bitcoin and blockchain:

A. In 1997, Adam Back developed Hashcash and introduced the proof-of-systems to limit email spam and SHA-I Hash as the header

B. In 1998, We Dai developed b-money which introduced public key identify pseudonyms, broadcast solutions to computation problems, arbitrator and fine schedule

Video Resources

James provides strategic finance consulting to technology startups by applying the practices learned through more than 20 years of experience in both startups and public companies. As the interim CFO for early-stage technology companies, James is responsible for strategic and financial analyses, budgeting and planning, cash management, board of directors and investor presentations, human resource management, fundraising, capital structure planning, and business performance measurements and metrics. James has an MBA from Harvard Business School and a Bachelor of Science in Systems Engineering from the United States Military Academy. He also leads Bay Area support for the Admissions Office of the United States Military Academy. Read James's full bio.